Blog (29)

I think every "value" investor has their what did Cramer just say moments. I certainly fall in that club. I occasionally watch the show to catch interviews with the CEOs that he interviews while I do my daily exercise routine. One rare occasions I will continue watching past that point (I know, I know, what was I thinking?) and one two occasions I listened to what is, in my opinion, really poor advice. The instances and my comments are detailed in the following post..

Before we begin I have to mention that Andy Kilpatrick is coming out with another edition of his classic work on Warren Buffett. Be sure to contact Andy or head to Amazon to order a copy.

Jim Cramer Mad Money Show, 03/10/2011

"Hey listen, I get it... I've been there... caught owning too much stock into a hideous sell-off... a nasty sell-off... like the one we had today with the Dow plummeting 228 points. I've been there, not knowing what to do. The propensity... the desire... to take sweeping, drastic action. And get out now, so to speak. I get it. Why not?

Think about it. It's everything gone wrong... What's gone right? I mean everything. Employment claims at 8:30am today. Reversal of the positive trend. Right back down. China? Clearly slowing. We know that from the deficit number. Tech, hitting the wall. Best themes out there... mobile internet tsunami, tablet... stalled out. Oil. Going down. But because of demand destruction, not the destruction of Colonel Ghadaffi. Spain is collapsing. Oh thanks! Can Italy be far behind? I mean, that's all tied to Libya anyway. Agricultural trade seems dead as a doornail. QE2? On the verge of ending. Taxes going up all over the place.

So how do you resist? How do you resist selling everything?...

Well tonight I'm going to give you your crisis playbook for dealing with this particularly awful, unrelenting moment.

First... this may surprise you... but you do have to sell something. You have to sell something. Too many things are going wrong right now. Way too many. Not a lot of silver linings. And look, I'm a silver lining kind of guy. And not everything you own is equally good. Some of it is probably pretty bad... pretty darn bad.

So I want you to sell something. Hey listen, take a loss. It's okay. First loss is your best loss. Got some big profits in a stock? Don't give them back. Ring the darn register. That's fine. You can always buy it back lower if you really like it, when the risk/reward is more in your favor, and it is not in your favor right now. But... and a big "but"... do not blow out of all of your stocks. Do not panic. That's stupid. Don't blow out of everything. Don't give up on stocks entirely. Don't hide in Treasuries. Do not hide in Certificates of Deposit with those puny yields. Instead, get ready to redeploy your capital into stocks that are selling off, because not all of them deserve to go down. Get ready... get ready in this sea of red to add to something you really like."

Comments like this reinforce my view that watching Mad Money is dangerous to your financial health. I mean seriously if you can't handle a 1.87% one day decline in your portfolio you shouldn't be investing in equities PERIOD.

What Cramer is trying to tell you is that you should always have money on the side to take advantage of market down cycles. That is absolutely something we can agree with him on. We like the motto of the boy scouts: Be prepared. Why pick a down day though to send this message? It's not like any of the issues he speaks about are new issues. Why didn't he pick a day when the market was up a HUGE 1.87% to tell investors it might be a good time to take money out of equities?

He is right in that it's not a time to panic but telling people to sell something and take a loss because of a one day drop is frankly poor advice at best. As I said earlier if you aren't comfortable holding the stocks in your portfolio during a 1.87% drop in the market you shouldn't be investing in equities, it's just that simple.

You should only sell your investments when they are selling above a price that you think is in excess of what your estimates of its current intrinsic value is (and its future intrinsic value growth rate) or when you find a company that you understand that is selling for a significant discount to its intrinsic value. The fact that the market is down 1.87% should not make you want to sell anything.

As concentrated investors we suggest that they only prudent course of action when markets are priced such as they are now is to keep a comfortable margin of cash on hand to take advantage of opportunities that present themselves. If your using margin, stop. You should be able to sustain a nice return over time without it and avoid the downsides of having levered up in an up market.

Further Jim Cramer Shenanigans on Mad Money Show, 03/29/2011

Well once again Mr. Cramer comes out with more shocking financial advice on his television show. I'm sure regular readers of this blog will not fall for his comments but his efforts to "teach" investors is likely to do more harm. Essentially he tells his readers that by listening to him they will profit on the next group of likely momentum stocks. Ignore the valuation he says, we all know they are overpriced, but some suckers are sure to drive the price up. What will likely happen is that he will encourage people to get in they will make some money (maybe) and then the stocks will run up some more and they will get back in and become the suckers that hold on too long.

"Here's what's going to happen. Within the next year, we're going to see IPOs... Twitter, Groupon, Zenga... that's gaming... as well as LinkedIn probably, maybe Facebook... They will be huge deals. I would bet that the smallest one might be Zenga... Zenga at $10 billion. The others will be worth more than that. Maybe much more. Those who get in as venture capitalists will make fortunes here. Those who get in on the IPOs will also make fortunes. But those who buy in the aftermarket? Uh... initially maybe. Later on, hard to say.

As fortunes are being made in these stocks, the critics will come out of the woodwork. And you know who they will be criticizing? Me! Why? Because I will be trying to get you in. I'm going to be trying to make you as much money as possible. And you will make money until it all blows up. And hopefully when it does, you'll have taken so much off the table, that you'll still have a massive win... a net win.

If you go read Confessions Of A Street Addict, I knew the valuations were all wrong during the dot-com bubble. I knew it was absurd. I recognize that it was a repulsive era, and agreed with those who said it was all nuts! That said, there was one big difference... the same difference this time around... I want you to make hay with the bubble, while the sun shines. I don't want you taking counsel with the bears initially. Once we've made a lot of money, that's a horse of a different color.

In other words, I am telling you that I have seen this picture before, and it ends really badly. But... and this is what the naysayers don't understand... you don't have to stay until the end of the movie!

By the way, I don't care that this new crop of IPOs is better than 1999 era batch, because they'll be colossally overvalued anyway. So they're not based on eyeballs or revenues, but so what. It's going to be overvalued. In fact, I'll even stipulate that they're even more overvalued than the bears think. Yet that fact is totally irrelevant. It's an abstraction, at least in the beginning. And I'm willing once again to risk my reputation, both telling you when to get in, and more importantly when to get out. The easiest thing to do is say it's all overvalued and I don't want to play and it will make you nothing!

It's my job to try to make you something. So I will fight to get you in. And then before the movie ends, I will do my best to try to get you out, because that's how real money is played..."

To conclude any fan of Cramer should take heed of this quote by Mr. Buffett:

"I mean, when times are good, it is kind of like Cinderella at the ball. She knew at midnight that everything was going to turn into pumpkins and mice, but it was just so much damn fun, dancing there, the guys looked better and the drinks got more frequent and there were no clocks on the wall.

"And that's what happened with capitalism. We have a lot of fun as the bubble blows up, and we all think we are going to get out five minutes before midnight, but there are no clocks on the wall."

In the quote he is referring to how incentives can influence behavior but the quote is just as relevant for this article. There is no place for momentum plays in a proper investment strategy and Mr. Cramer should be ashamed of himself for using base psychology plays to get people to follow his dangerous investment thesis.

Mr. Greenberg is the managing director of Brave Warrior Capital (formerly he was one of the founders of Chieftain Capital). He is a concentrated investor with a superb long-term track record.His comments on investing are rare so when I happen to find a new source of information on or about him I devour it. This blog covers comments from a presentation he gave at the Columbia business school.

In this blog I have attempted to transcribe comments that I thought were especially interesting.In the interest of keeping the length (cough) reasonable I was forced to leave out quite a bit of material and so I would recommend anyone who has the interest to listen to the speech via the Columbia internet site (see links at the end of the document.)

I have tried to transcribe his comments verbatim with a minimum of adjustments to provide better flow of his ideas.As such any mistakes found are entirely my own.In certain areas of the document I paraphrased portions of his comments and I have annotated theareas as such in the write-up.

I hope you can accept the limitations of the document as I feel there is a lot to learn by a careful study of his comments. Feel free to email me if you would like a copy of this blog in PDF format. rich@focusinvestor.com.

[13:16] ...now I have a new company and I've learned a lot of things that I had forgotten over 26 years (at Chieftain). Number one I learned that when I don't read 10ks and study the numbers myself I don't really have the tools to make good investment decisions and I didn't really realize it because the young guys that came out of [intelligible} Hall were computer literate and started building models.Wow this is pretty cool, you can project out, put in more variables so it became a very model driven place.It used to be a yellow pad, studying the 10K and putting down key numbers, looking at the historicals, asking questions of management and getting a good sense of where business might be heading in the next couple of years.Trying to decide is this a good business, is this a business I want to own if we go through another 1987 or 2008 or is this something the wheels could fall off.

First you decide that the business is a good business then you decide is it cheap, what is the outlook [intelligible] but I've rediscovered without reading the source material you really don't have the information.Another thing that I found since we have now brought on two younger people to work with us is that they come in and they use Capital IQ which I'm sure some of you are familiar with and I have now after a few months of working with them decided that we should ban Capital IQ because it's so riddled with errors that whatever time you think your saving, the numbers just aren't useful.They're wrong and if they're wrong you're going to be totally misguided and you're not going to get anywhere.

I urge you to lay off the numbers that are prepared by others and take the extra few hours, at first it will be slower and more cumbersome to do them yourself and scrub the numbers but soon you will be get super quick at it.It will tell you what numbers you really need to focus on.I have memos that have 761 lines of stuff, masses of numbers,but really any company that you're looking at you want to boil it down to a much smaller number.They're certain major issues at any company you look at.

An example, we own Google.You can say how there is so much you don't know?One thing I do know is that people now spend about 30% of their time on the internet.Thirty percent of the time and its only 10% of where all advertising is done.I'm willing to make the bet that over the next five to ten years the amount of advertising is going to catch up with the amount of time people are spending on the internet.I don't know what shape it will be and I don't know if Facebook will be able to do it better but I'm convinced that Google with 50% share on online advertising will get its fair share.There is also a lot of optionality in all the things that have poured money intothat aren't on anyone's radar screens yet. Obviously the nature of their business generates a staggering amount of cash.I can do a little model of that obviously but in a sense it's really a bet that people spending thirty percent on their time on the internet that advertisers are going to find a way to get in front of those people when their on the internet.

You can model a lots of different things and they are a lot of numbers but in the end investing is making a bet.Being a good investor is going through all the numbers and picking out those that really say something, that are very meaningful, and those are of you that want to be investors are going to have to learn about what's key in driving an investment.

When you are going to talk with management start by saying to yourself if there were three questions I could ask that I could give truth sermon to the CEO what three questions would I ask that the answers to would tell me whether I should be an investor.And I'm not talking about whether their earning are going to be $4 a share.Ask more strategic questions, don't get lost listing 35 questions that you have pulled out that are in no particular order and then you start working your way through the list.Go for the questions that are really going to make your mind up pretty quickly about whether this is something you want to explore further or something to forget about.

[20:15] I can give an example.I'm very interested in Abbott.Abbott trades at 52 and this year it's free cash flow will be about $5.20.It's trading at 10 times free cash flow.It's a hell of a company, it's had a great record, it has a very astute management that has made great acquisitions, it's not overspent on R&D.It's orientated towards prime illness which will be a long, long runway [intelligible].The problem is that it has onedrug which is a treatment for rheumatoid arthritis, called HUMIRA, that is about 45% of their earnings and growing fast and will eventually go off patient.A very complicated, there is only one example of this kind of a large molecule drug being made generically.This could make the end more gradual but eventually all things come to an end.

So if I'm going to meet with the CEO the question I would ask is how he thinks about the maturation, how he thinks about a company that has about 45% of its earnings coming from one drug and will probably have 55 plus percent of its earnings coming from that drug when it has its first competitor come off patent and then we it comes off patent.How is he thinking about it, what steps is he taking to prepare because that is really the key investment issue.Press him on his answers.

[22:20] Another example, Ryanair in which we have a big position. Ryanair is a low cost European carrier which was designed from scratch to be (modeled after Southwest Airlines)...

The big question is that they are running out of ordersso in 2012 they will go into a very different mode.Instead of growing 15-20% per year in new capacity they will essentially have no new capacity.

The number one question would be do you want to stop growing or do you want to make another order?If you can make another order with Boeing what rate of growth do you want to go for?(Paraprhased)He is looking to see how their growth would affect yield (i.e. how many people in seats versus total plane capacity) and how they themselves think about the issue.He thinks that if the company never ordered another plane(they have a very young fleet) that conservatively projecting the cash flow of the company (taking into account higher maintenance expense as the fleet ages) and discounting it back to the present would yield about a 13.5% return (not certain what stock price he was considering).He would ask management if they had thought about that and base their plans against that bogey.

[38:15]Find managers that are ruthless in the way they run their business.

[39.07]I completely believe in investing in good businesses.One of the time that it was driven home to me was in 1987 when the market fell 18% in one day, 40% in one month,I made 23% in one day.I made up my mind at that point that could happen again and I was just going to own only businesses that if that happened again I'm fine with.I'm fine with the stock being down, I believe in the business, the value will recover.Not get into short-term plays, buying some junk because you hear stories.That is when you would no doubt sell for huge losses.

[52.09] I can't say enough about doing your own homework and then thinking about it.

[1:12:34] Question: I wanted to as you about DCF model and what hurdle rate you using now and how did you get it.Also do you use the same hurdle rate for different companies and different sectors?Do you also use it to decide the selling price as well?

When I first started in the business every company that I ever analyzed I did on a yellow pad which wasn't exactly conducive to a DCF model. The young people who came into my firm all were computer literate and developed the DCF model which became the model around the office.The model was utterly useless in the last few [intelligible], utterly useless.So I am now, in my new firm, going back to the way I used to do things which is basically have a very clear view on why I think it is a good business, a business that can grow, the quality of the business and a very clear view of where I think the business will be in the next few years.

(My comment:In the book, Value Investing from Graham to Buffett and Beyond, p. 219 discusses his early years and provides additional background information:

"Greenberg likes companies that produce a stream of free cash flow, so it makes sense that he uses an estimate of cash flow to tell him the value of those firms.Before the arrival of the personal computer and the electronic spreadsheet, he and his partner would analyze a company by isolating its business segments and projecting revenues and expenses no more than two or three years into the future.By assuming that it would grow steadily from then on, they could calculate its current value by discounting that cash flow back to the present, using only a hand calculator.")

The way I would probably think about the DCF I would start out with the FCF yield today and think about what I think the business is capable of growing say over the next five years and if that comes up to something like 15%, the combination of the free cash yield today plus the grow rate that I think is reasonable then I think I've got a pretty good investment.The reason I think that is because I think the market probably, over time,you tell me, you pick a rate, 7, 8, or 9 percent if I have something that is going to get me 14 or 15 percent that is clearly undervalued relative to the market that is priced to give me 7, 8 or 9 pick a number.I think that I'm very down on computers, I think they are a complete waste of time.I don't know how Warren Buffett feels about them, you should ask him about them.

(My comment:It's interesting that his son Spencer, has developed an computer AI based approach to investing at Rebellion Research, a small NYC based hedge fund.As of July 2010 the firm was doing quite well.)

Bruce Greenwald:You did.He feels the exact same way expect for instead of using the hurdle rate of fifteen percent use thirteen (My comments:Is this because of his smaller investment universe?I think so and so don't believe that comment is as relevant to smaller investors).

Greenberg:That was a time when stocks were really high.Believe it or not, when the business was easier, I used to ask myself couldI see how the stock would be up at least 50% on the next two years based on where I saw the earnings develop over the next two years.That was sort of the hurdle rate.{Paraphrased) Over time as market when higher this got to tough to do without projecting extremely aggressively and in the 2008 area interest rates were low.

I asked Warren how low (hurdle rate) do you go and his answer was 13%.

So that is my new way of thinking about things:free cash flow yield plus reasonable rate of growth, business that I have confidence in and I'm not going to wake up one day and the thing has fallen apart and I try and get the best group of those in my portfolio.

(My comment:Interesting that he is willing to adjust his approach because at one time the DCF spreadsheet model seemed to be a key part of his investment process.)

If you have visited this site before you certainly know which investors that I respect. The list of living investors would include Warren Buffett, Charlie Munger, Seth Klarman, and James Montier. I added another investors to that list several years ago but I think this is the first time I have mentioned him here on the site. Now is the time to bring him to your attention as I recently discovered he will have his first widely available book published in May of this year.

He is well known to institutional managers and distressed debt investors for his investing memos that he publishes when he feels he has something relevant to say. As an individual investor you may not have heard of him as his firm doesn't market itself to retail investor (they don't invest in public equity markets) and he does seem to stay out of the limelight.

His writing strike a cord with me for several reasons. He is a big believer in behavioral investing and his firm is one of the few on wall street (Seth Klarman coming immediately in mind as another) that has a sharp focus on only investing in areas of the market that are currently experiencing inefficient pricing. Many firms say they follow this manta but few practice it religiously. The firm does not have funds for every investment category that one could possibly dream up which again confirms that they practice what they preach.

After reading his memos available on the Oaktree Capital internet site (there is also a hard cover book titled Memo to Oaktree Clients from Howard Marks printed by Wave Publishing but it is hard to locate) it was immediately apparent that he deserved to be compared to the best writers in the industry and someone it would pay dividends to follow closely in the future.

A reading of the memos provides a wealth of valuable investment knowledge and they're comparable to Warren Buffett's Berkshire Hathaway letter to shareholders in terms of quality and wisdom shared.. I can safely predict that this book will be a must read for investors. Don't just take my word for it as Warren Buffett and Seth Klarman both provided blurbs for it. I have asked the publisher for a review copy of the book and if I do obtain one I will provide a detailed review as soon as possible.

"Since the formation of Oaktree in 1995, Mr. Marks has been responsible for ensuring the firm's adherence to its core investment philosophy, communicating closely with clients concerning products and strategies, and managing the firm. From 1985 until 1995, Mr. Marks led the groups at The TCW Group, Inc. that were responsible for investments in distressed debt, high yield bonds, and convertible securities. He was also Chief Investment Officer for Domestic Fixed Income at TCW. Previously, Mr. Marks was with Citicorp Investment Management for 16 years, where from 1978 to 1985 he was Vice President and senior portfolio manager in charge of convertible and high yield securities. Between 1969 and 1978, he was an equity research analyst and, subsequently, Citicorp's Director of Research. Mr. Marks holds a B.S.Ec. degree cum laude from the Wharton School of the University of Pennsylvania with a major in Finance and an M.B.A. in Accounting and Marketing from the Graduate School of Business of the University of Chicago, where he received the George Hay Brown Prize."

"...attempting to invest on the back of economic forecasts is an exercise in extreme folly, even in normal times. Economists are probably the one group who make astrologers look like professionals when it comes to telling the future."

I just love that quote as I believe it states, quite elegantly, the folly of paying closer attention to the macroeconomic picture when it would be an infinitely more productive use of time to concentrate on company specific issues and making a purchase when their is a big disconnect between your estimate of intrinsic value and its valuation by the market.

This brings me to another quote from the same article that I feel is especially important to focus investors:

"From the perspective of mean reversion, fat tails help to create some of the best opportunities. That is to say, fat tails often create fat pitches."

The author came up with a great premise for this story with the type of inverse thinking that would make Charlie Munger proud. He decided to examine not just how the stocks that analyst recommended as their top picks performed but he went one step further and decided to look at how their sell recommendations performed. I doubt any regular reader of this site will be surprised by the outcome.

"I asked them (Thomson Reuters) for the 10 stocks that analysts rated most highly a year ago. These stocks were the cool kids on the Street. The ones everyone wanted to hang out with. How did they do? Not bad. If you'd invested $1,000 in each one a year ago, your $10,000 stake would have grown to nearly $12,400 today - an impressive 24% return. By contrast, the S&P 500 overall gained just 13%."

As you suspect the losers that nobody wanted to own earned 32%. It's a great article and I recommend you head over to the WSJ and read the whole thing.

3. Portfolio Differentiation?

(Pack Mentality Grips Hedge Funds, WSJ, 01/14/2011)

The last musing to start the new year highlights another area in investing that focus investors can potentially take advantage of to outperform professional investors.

The article discusses how hedge fund managers seem to have very similar holdings in their portfolios. This example, one of several in the article, highlights the issue:

"Sometimes groups of like-minded funds pour money into the same securities. That what happened with funds connected to veteran manager Julian Robertson of Tiger Management... In 2008 and 2009, as many as 10 of those funds held large positions in MasterCard, according to filings by AlphaClone.

The Visa trade was even more popular, holding the top spot by the first quarter of 2010.

In May, the Senate voted to restrict debit-card fees... Within days, Visa and MasterCard plunged 22% and 18% respectively. The stock (Visa), which had been among the top 10 holdings of 177 hedge funds AlphaClone tracks, dropped from the top 20."

So what lesson can be taught from this article? Look for opportunity when a company goes from adored to hated. This Visa opportunity may not have been the right one but when a stock hits a bump in the road and its fall is compounded by extensive selling pressure it certainly increases the chance that a long-term investor might find a golden opportunity to take the other side of the trade.

Pension funds should be dream clients for focused value investment managers. They have a long-term time horizon which should allow them a major competitive edge; the ability to take advantage of the market when its participants fall into despair. In my view, they have completely failed use their built in advantages because of significant structural problems, i.e. they hire money managers who commit a major investment faux pas, they perceive that volatility equals risk, which is a completely false truth foisted on us largely by academics. Volatility has no connection to risk when risk is defined, appropriately, as the chance of permanent capital loss.

Using consultants and placement agents can lead to additional problems. For instance CalPERS has experienced problems related to kickbacks. According to a recent story in The Deal ".. a former CalPERS president resigned from the board of the Los Angeles Fire and Police Pensions after the SEC sent a letter inquiring into his financial disclosures and dealings with Weatherby (where a former employee pleaded guilty to a securities fraud charge) and other consultants. Several other former board members have been served subpoenas or are ensnarled in civil litigation. All have denied these charges and in several cases in the end no charges were brought against them. CalPERS has since strengthened its policy on the use placement agents and the payment of fees.

They have been so focused on boosting returns as much as possible, mainly because they use excessively optimistic growth assumptions which has led to a historical underfunding of the plans. This causes them to chase hot sectors such as in the 1990s when they, according to a October 16, 2010 WSJ article, "...loaded up on stocks in the booming 1990s and had almost 70% of their money in them by the mid 2000s." The article continues but letting us know that, as of July, the pension funds have changed their views and have decreased their allocations to stocks to 45%.

Not only did pension funds wade into the stock bubble, they also went knee deep into the private equity bubble. For instance, as related the recent New Deal article:

"Between 2006 and 2008 CalPERS poured about $8.4 billion into 15 of the 20 largest buyout funds raised during that period."

Leaving aside what they should have done in those periods and how they should be positioning themselves going forward, for the moment , let's take a look at the same WSJ article mentioned above to learn what they are doing. In the article Towers Watson conducted a survey that revealed "..on average, they were planning this year to move 10% of their assets out of stocks and into bonds and alternative investments."

So as you can see they overloaded on stocks when stocks in general were highly priced and now they are moving into bonds during what is sure to develop to be a massive bubble in bonds during a period of historically low interest rates. The comedy team at Saturday Night Live would be hard pressed to write a better script.

Lest you think this tale of missteps is a one off occurrence let's examine what Mr. Buffett had to say in a New York Times article dated August 31, 1979 (which essentially quoted his Berkshire Hathaway letters to shareholders):

"In 1971, pension fund managers invested a record 122 percent of net funds available in equities [buying some with borrowed money at full prices]. In 1974, after the bottom had fallen out, they committed a then-record low of 21 percent to stocks."

"In 1978 pension managers, a group that logically should maintain the longest investment perspectives, put only 9 percent of net available funds into equities - breaking the record low figure set in 1974 and tied in 1977."

The situation is a tragic romantic comedy in which they constantly make the wrong choices in love. So how does all this relate to focus investors? This is yet another example of irrational behavior that we, who do have long term horizons, and don't equate volatility as risk, can take advantage of.

From an interview Warren gave with Beck Quick on CNBC about his biggest investment mistake. I thought his comments on investment purchases would hit home with focus investors.

BECKY: So that is a lesson you carried with you? And yet, it's one that is—you're reminded of every single day. It's Berkshire Hathaway.

BUFFETT: Yeah. And every now and then, I get tempted. Because I started out with Ben Graham in 1950 or so. And his whole idea was buying things that were cheap. You don't want to buy things that are cheap.You want to buy things that are good. It's much better to buy something that's good at a fair price, than something that is cheap at a bargain price. [Italics added] And I wasn't—I didn't start out that way. I was taught a different system. But—but if I didn't learn from Berkshire Hathaway, I'll never learn.)

I just read this section of a speech by Mr. Graham and I enjoyed it so much I feel compelled to share it with you all:

"...the second episode (first referred to the publication of Common Stocks as Long-term Investments which Mr. Graham believed help provide the foundation for the bull market in the 1920s) - historical in my thinking - occurred toward the end of the market's long recovery from the 1929 to 1932 debacle. It was the report of the Federal Reserve in 1948 on the public's attitude toward common stocks. In that year the Dow sold as low as 165 or 7 times earnings, while AAA bonds returned only 2.82%. Nevertheless, over 90% of those canvassed were opposed to buying equities - about half because they thought them too risky and half because of familiarity. Of course this was just the moment before common stocks were to begin the greatest upward movement in market history... What better illustration can one wish of the age-old truth that the public's attitudes in matters of finance are completely untrustworthy as guides to investment policy.

I think the future of equities will the roughly the same as their past; in particular, common-stock purchases will prove satisfactory when made at appropriate price levels."

p. 248 of Benjamin Graham, Building a Profession edited by Jason Zweig and Rodney Sullivan

I would add that you should take this wisdom and, as Mr. Munger likes to say, invert it in order to stay away from the areas of current rampant speculation. I would, at present, define those areas as gold and bonds.

I recently finished reading the book Capital Account: A Money Manager's Report on a Turbulent Decade 1993-2002. The book is full of investment wisdom and I would recommend purcashing a copy if you can find one.

Basically the book contains experts from their newsletter the Global Investment Review. As their site says its "...published eight times a year and contains approximately six articles. Its aim is to provide clients with Marathon's latest investment thinking and (at times irreverent) commentary on events in the business and financial world. The first GIR appeared in January 1987, shortly after the establishment of Marathon."

If you can't (or don't want to purchase the book) I would recommend at least reading the PDF copies of several of their past GIRs that are available on their internet site at:

Mr. Munger recently made a somewhat surprising announcement to the effect that Li Lu is basically one of the projected capital allocators for Berkshire Hathaway when he was quoted in a recent WSJ article stating ""In my mind, it's a foregone conclusion". There has been a mixed reaction to this article I and thought it would be interesting to blog about what Charlie sees in him and to see how Li Lu approaches investing.

The article relates the only solid return data that I have seen to date about his investment returns which, according to the WSJ article, his "...hedge funds have garnered an annualized compound return of 26.4% since 1998, compared to 2.25% for the Standard & Poor's 500 stock index during the same period."

I have no personal knowledge, other than what I have read (his biography about his time in China) and two videos of lectures he gave at Columbia University that I watched. I have no idea what investments he made that comprise his track records, other than an investment in Timberland and BYD. Despite this I will try and explain the reason why I think Charlie is enamored with him.

So first let's start the discussion by drawing on comments Charlie made at the 2007 Wesco annual meeting when he spoke about what characteristics had made Br. Buffett so successful.

Here is the list:

1. Mental aptitude

2. Warren has a strong interest in what he is doing

3. Warren is a learning machine. In fact Charlie said that "Warren's investing skills have markedly increased since he turned 65."

4. He is able to make his own decisions and he is very objective in making those decisions

5. He reinforces those people that are close to him

Just looking at the publically available history of Mr. Li obviously has triumphed over a number of adversities over his life which shows us that he develops firm convictions and is not deterred when his convictions conflict with others. He fought for what he believed in when he was in China, under a repressive government, he came to the United States only able to speak a minimal amount of English and ended up graduating from Columbia University. While there he developed an interest in investing that was reinforced when he listened to a lecture from Mr. Buffett.

As the article mentioned he used a portion of his book advance money to start investing. He did well and eventually stated his own hedge fund company in 1998 called Himalaya Capital (the internet site is still up and is updated. The link is: http://www.himalayacapital.com/).

Since that time he has focused on the investing field and I'm sure he has developed a process that has been refined over time into a form that Charlie obviously thinks highly of since he gave Mr. Li personal funds to invest.

I'm sure all those factors, i.e. his strength of character, obvious mental aptitude and his strong interest in investing made him interesting to Charlie. As Charlie also said at the 2007 Wesco annual meeting, "We like a peculiar mindset. People chosen won't look like standard people. Obviously we'd like to try to get somebody that reminds us of Warren."

I also thought this quote from Li Lu's foreword to the Chinese edition of Poor Charlie's Almanac is instructive of how Charlie did he due diligence on Mr. Li:

"Seven years after we've known each other, at a Thanksgiving gathering in 2003, we had a long heart-to-heart conversation. I introduced every single company I have invested in, or researched, or am interested in to Charlie and he commented on each one of them. I also asked for his advice on the problems I've encountered. Towards the end, he told me that the problems I've encountered were practically all the problems of Wall Street. The problem is with the way the Wall Street thinks. Even though Berkshire Hathaway has been such a success, there isn't any company on Wall Street that truly imitates it. If I continue on this path, my worries will never be eliminated. But if I was willing to give up this path right then, to take a path different from Wall Street, he was willing to invest. This really flattered me.

With Charlie's help, I completely reorganized the company I founded. The structure was changed into that of the early investment partnerships of Buffett and Munger (note: Buffett and Munger each had partnerships to manage their own investment portfolios) and all the shortcomings of the typical hedge funds were eliminated. Investors who stayed made long-term investment guarantees and we no longer accepted new investors.

Thus I entered another golden period in my investment career. I was no longer restricted by the various limitations of Wall Street. The numbers still fluctuate as before, but eventual result is substantial growth. From the fourth quarter of 2004 to the end of 2009, the new fund returned an annual compound growth rate of 36% after deducting operating costs. From the inception of the fund in January 1998, the fund returned an annual compound growth rate in excess of 29%. In 12 years, the capital grew more than 20 folds."

So what does Mr. Li say about his investing philosophy. His quotes are few and far between but I was able to locate a few. This first quote is from a May 1998 article in the New York Observer by Carrie Cunningham (http://www.observer.com/node/40526):

"Mr. Li said he likes to buy stocks that are undervalued, in his estimation. That goes against the currently fashionable "momentum" theory used by investors who believe they can ride an overvalued stock that is still soaring in price, and then jump out before the stock comes crashing back down.

"If you're right, ultimately it will prove you're right, but you look stupid for a long time," he said of his own gambits. "It is what I'm all about. It's revolutionary. It is about trusting yourself. It's about challenging the conventional wisdom. That's what we did in Tiananmen."

This additional quote from the recent WSJ article clearly highlights the similarity between Charlie's approach to investing and Mr. Li's:

"Mr. Li told investors he took a lesson from watching the World Cup, comparing his investment style to soccer. "You may very well work extremely hard and seldom score," he says. "But occasionally—very occasionally—you get one or two great chances and you make decisive strikes that really matter."

Compare that to this quote from Charlie from the book Damn Right!:

"Playing poker in the Army and as a young lawyer honed my business skills. What you have to learn is to fold early when the odds are against you, or if you have a big edge, back it heavily because you don't get a big edge often. Opportunity comes, but it doesn't come often, so seize it when it does come."

So as you can see I think it's pretty clear why Mr. Munger concluded that Mr. Li is the right candidate. He has the right intellectual background, he is an independent thinker, he sticks to his convictions and he is not afraid of volatility. For more insight into his investment philosophy I would recommend a careful study of notes on his lectures at Columbia University which are available at: http://streetcapitalist.com/2010/06/24/li-lus-2010-lecture-at-columbia/

"Let me emphasize that it does not take genius to be a successful value analyst, what it needs is, first, reasonably good intelligence; second, sound principles of operation; and third, and most important, firmness of character." Benjamin Graham, The Intelligent Investor.

One change in my thinking from the first edition of my book is that in it I advanced the idea that anyone could become a successful focused investor. I now believe that anyone can become a focused investor but in order to do so they must devote a serious portion of their time to learning the process of investing.

What changed my thinking? I had been developing this thought for some time but it really coalesced when I read Chapter 2 of Outliers: The Story of Success by Malcolm Gladwell. The whole book is very well done but when reading the section in which he writes about the Beatles, Bill Joy, and Bill Gates and how they all become quite successful really made me think about the issue in more depth. He develops a theory about how they became so successful. In essence they are achieved a high degree of success because they wholeheartedly put many hours of work into developing insight and skill at their chosen passions.

For instance, Bill Gates had access to a computer during a time when being able to spend large chunks of time on one was quite rare and he was able to become quite skilled in a field that was in its infancy before most people even realized the field existed.

The Beatles went to Hamburg, Germany five times over a two year period where they employed to play gigs, night after night. Mr. Gladwell estimates that over this time frame the Beatles played 270 nights. This experience was an extraordinary gift as it provided them with the ability to work together, develop a stage persona, try out ideas, and in short develop and refine the processes that help make them a success later. As we shall see a little latter in this narrative though just spending 10,000 hours practicing something is not a guaranteed path to success.

I however found myself wondering if passion and repletion were the only reason they were successful? I wondered if some sort of natural ability might also play a factor. Thankfully I happened to read a book that addressed this question: The Genius in All of Us by David Shenk.

In the introduction to the book he discusses the baseball hitting skills of Ted Williams. The author tries to dispel various myths as to why Mr. Williams was such a good hitter. He stated that baseball fans thought of him as having "...a collection of innate physical gifts, including spectacular eye-hand coordination, exquisite muscular grace, and uncanny instincts."

What did Mr. Williams think of this as an explanation of his ability? Not much as is clearly evident in his reply: "Nothing except practice, practice, practice will bring out that ability... the reason I saw things was that was so intense... It was discipline, not super eyesight."

This discipline was apparent from an early age. When interviewed friends from his youth recall him constantly hitting baseballs. In fact they related that he would hit the balls so many times to practice his swing and stance that the outer shells of the balls would be worn completely off when he was finished with them.

When he achieved his dream of reaching the big leagues his search for hitting knowledge didn't slow down at all. This drive was evident to his biography writers Jim Prime and Bill Nowlin, "He discussed the science of hitting ad nauseam with teammates and opposing players. He sought out the great hitters of the game - Hornsby, Cobb, and others - and grilled them about their techniques."

Mr. Shenk also wanted to highlight that child prodigy's where not born with natural gifts. For example he examined Mozart, who is often referenced as an example of a child prodigy. The real story behind his amazing skills starts with his father Leopold Mozart, whose passion was music, and just happened to be a music teacher and composer. His father might not have been a master composer but he had a gift for teaching music and had developed methods that were quite advanced for his time.

His father had already taught Mozart's sister, Nannerl, how to play and Mozart naturally developed an interest in the music that enveloped his family's world. Under this environment and with continuous instruction from his father he went on to achieve world acclaim when he was older but during his youth his level of performance is often matched today by children who are taught today under the same type of rigorous instruction regime.

Anders Ericsson, a Swedish psychologist, has studied the issue of talent and several themes seem to equate to achieving that goal. Among those that are relevant to developing skills in investing include:

1. Practice style is all important. His studies have shown that you need to use what Ericsson calls "deliberate practice" which he explains as "... [involves] repeated attempts to reach beyond one's current level which is associated with frequent failures." (page 55, The Genius in All of Us)

2. Short-term intensity cannot replace long-term commitment.

Ericsson studies revealed no genetic components that accounted for elite athletic achievement (with the exception being body size). Given this evidence the author of The Genius in All of Us concluded that "Becoming great at something requires the right combination of resources, mentality, strategies, persistence, and time; these are tools available to any functioning human being."

A final point that I want to make that reinforces the point I am making in this section is summed up on page 20 of the book Complications: A Surgeon's Notes on the Imperfect Science by Atul Gawande. He relates that K. Anders Ericsson, a "cognitive psychologist and expert on performance, notes that the most important way in which innate factors play a role may be in one's willingness to engage in sustained training" (italics by original author).

More...

I originally sent this as an email1318 to a friend in February of this year and I thought I would post it here as I still find the situation interesting.

The company is called MDS INC (Ticker: MDZ) (soon to be renamed to Nordion). The background history of the company is one filled with a legacy of value destruction but it has now sold all but its core business (more later) with the biggest legacy business being sold to Danaher recently for which the company received $650 million. At this point all the old business divisions besides Nordion have been sold but there are still some legacy obligations remaining.

The prior management team has been replaced, with the exception of the CEO of the Nordion business who is now the CEO. The company is now refocusing on its Nordion business, a medical isotope supplier.

So what is the deal here? Well medical isotopes are only produced, currently, in 5 nuclear research reactors, the newest one coming into service in 1965. Out of those five there are two that produce about 65% of the world's supply of medical isotopes. The HFR (Netherlands) and NRU (Canada) reactors are those 2. Nordion gets 100% of the Mo-99 produced from the NRU reactor and then processes it into Tc-99m and exports it to Lantheus who distributes it.

Tc-99m is used in 30 million patients yearly to treat a range of issues including Myocardial perfusion, bone scans, etc. Its advantages include low dose, a six hour half-life and a historically low cost. All these are also important competitive advantages that have kept away competition for 30+ years.

The business, under normal operating circumstances is solidly profitable.

So what is the problem? The first is that the NRU reactor is old and has been offline since late 2009 due to a small heavy water leak. That presents supply problems to Nordion which in turn has lead to unprofitable operations. The company had been working with a division of the Canadian government, AECL, to design and constructing two new nuclear research reactors, the now infamous (in these circles) Maple project which has now been completely stopped by the current Canadian government.

So with NRU down and Maple cancelled the stock is in the doldrums, for good reason.

Why even bother with this? Well when NRU gets back online (scheduled for late April but I have my doubts*) they should be up for a healthy time period because during the repair the reactor was completely shutdown. This allowed the AECL to do a bunch of additional work inside the reactor that it normally can't do (because the reactor was almost continually in service) which to date has included new wiring, critical values and chiller units. The AECL is going to put patches over the problem areas and so far is 48% completed*.

Weekly updates (as well as a bunch of informative videos talking about the process (can be seen at www.aecl.ca) The AECL is going to apply for a life extension with the Canadian nuclear regulatory agency to keep it running until 2016 which I think is highly likely to pass based on comments from the government, etc. So if they can get it back online and if they get the license extension Nordion should have a good period of profitability.

Value added action being taken:

The company is doing a buyback and will be purchasing between 40-46% of the outstanding common shares (This has since been completed. Their press release stated that "On March 29, 2010, MDS repurchased and cancelled 52,941,176 Common shares at a purchase price of $8.50 per Common share for a total cost of $450 million under the substantial issuer bid.")

Why might you want to look it more closely?

- Even after this the company with have a clean balance sheet with between $85-110 million in cash and no debt. (On Jun 14, they reported a cash balance of $134 million)

- The company could potentially receive a settlement from AECL (i.e. Canadian government) for a portion of the $350 million they spent on helping to develop Maple

- Will be quite profitable when they get supplies from NRU again and return to normal operations although it may take some time to return to earlier margins levels as customers come back on line

- Due to issues with the way product is developed (with Highly Enriched Uranium) there is no way this is going to be a program that doesn't involve cooperation with governments and there are unlikely to be any major sources on new supplies on the near to medium term horizon

Problems:

- With global supply issues causing the price of Tc-99m to increase users are looking for replacements that, so far, have meet resistance due to low price point. One such is PET technology may be more attractive

- New research is being done into the production of Tc-99m which could mean at some point could mean more competition

- Outlook is cloudy for when NRU will come back online and if it can get license extended to 2016.

*I was correct as the project was delayed with a new tentative date of late July. On June 30 the AECL posted in their regular updates that they believe the repairs have been completed and think the NRU can be returned to service. They further advised that they will be appearing before the Canadian Nuclear Safety Commission (CNSC) in a public hearing to consider AECL's application for the restart of NRU on July 05, 2010, at 2:30 p.m.

I receive quite a bit of questions about what it takes to find a job in this field. When I was reading the WSJ article published today called, Intern to Civilization Leader, I thought it was a perfect illustration of what I tell all of them. Do something useful to make yourself noticed and seperate yourself from the crowd. Also be persisent, if you're product is high it will get noticed. Just sending a resume and making a phone call expressing interest will seldom recieve any interest in such competitive fields as investing and gaming.

Here are some relevent quotes from the article:

Q: Internships at game companies are pretty hard to get. How did you land one?

A: I started out as a beta tester, playing new games for the company and asking if I could help out in any way. I kept pestering them until they finally acquiesced. They said they didn't have any full-time positions, but they could make a programming internship for me. That was in February 2005.

Q: Did you have much programming experience when you applied?

A: My father is a computer programmer for United Airlines. He would program me little games for fun, just on his own, really primitive stuff. I kind of picked up on that and started doing it myself. At 9 or 10 years old I was programming simple games. I [started out] majoring in computer science at Colorado State University. But most of what I know now about making games was learned at Firaxis while I was an intern. How You Can Get There

A: Early on, I did very basic programming tasks that the lead programmer needed done. But I was also making scenarios and maps [for the Civilization game] while in the internship. It wasn't related to what I was doing but it was stuff I found interesting—and so did they. Eventually, they told me they were making expansions [add-on game scenarios] for Civilization IV, and they needed designers to make stuff. That's when I got the job. I was hired on as a full-time designer after getting my degree.

Q: After double majoring in computer science and history, you dropped computer science in favor of a history degree. Has that affected your career?

A: From a very young age I've always had an interest in history, World War II in particular. When other people were reading "Goosebumps," I was reading [the book] "Panzer Battles." It ended up playing a major role in what I've been doing because Civilization uses history as a foundation for everything that takes place. It's important to know the flow of history and the different major events that people will recognize. When I moved to take the [intern] job at Firaxis [in Maryland], I finished my degree at Towson University. Even as an intern, I was working full-time and dropped the double major to work just on history

Best advice: "It's a very competitive field and it's more than just playing a lot of games," says Mr. Shafer. "You have to separate yourself somehow."

Skills you need: "Being well-rounded and having perseverance," he says. "Knowing programming is third."

Where you should start: "Be proactive. Make your own opportunities," he says."

I received this in my email1318 earlier today and thought I'd share it with my readers here and make a few comments after it.

U.S. Bonds Resemble Internet Bubble, Citi Says: Chart of Day

2010-08-17

By David Wilson

Aug. 17 (Bloomberg) -- U.S. bonds may be just as vulnerable to a plunge as stocks were a decade ago, when the Internet bubble burst, according to Tobias Levkovich, Citigroup Inc.s chief U.S. equity strategist.

The CHART OF THE DAY depicts how an index of monthly returns on 10-year Treasury notes since 2000, as compiled by Ryan Labs, compares with a total-return version of the Standard & Poors 500 Index from 1990 through 2005. The latter gauge peaked in August 2000 and tumbled 38 percent in the next two years.

The similarities should cause anxiety, Levkovich wrote yesterday in a report with a comparable chart. He calculated that the 10-year note had a 0.87 correlation with the S&P 500 of a decade earlier, which meant its performance followed much the same pattern.

Another parallel, he wrote, is that investors are moving into bond mutual funds in the same way that they poured cash excessively into stock funds back in 2000.

About $561 billion has flowed into bond funds since the beginning of last year, according to data from the Investment Company Institute. Stock funds, by contrast, had a $42 billion outflow during the period.

=========================

A theme that also strikes home with me in investing is that people always seem to extrapolate recent events into the future. Just like in the late 1990s when money recklessly flooded into equities to chase recent good performance investors are now rushing into bonds looking for extreme levels of perceived safety and disregarding high quality equities which are now sporting the most attractive valuations in years (some of which also have dividend yields in excess of 10 year U.S. treasury notes).

On Monday I happened to come across a 1979 New York Times article that referenced Warren Buffett's 1978 Berkshire Hathaway Letters to Shareholders and highlighted his comments on institutional asset allocation. I believe it would be instructive to quote it here with the Bloomberg comments in mind:

"An irresistible footnote: in 1971, pension fund managers invested a record 122% of net funds available in equities - at full prices they couldn't buy enough of them. In 1974, after the bottom had fallen out, they committed a then record low of 21% to stocks.

A second footnote: in 1978 pension managers, a group that logically should maintain the longest of investment perspectives, put only 9% of net available funds into equities - breaking the record low figure set in 1974 and tied in 1977."

So what is the situation today concerning the allocations of pension funds and other institutional investors? Let's examine a few relevant quotes from around the world to see if the same behavior that Warren mentioned is happening again.

The first quote is from an April 17, 2009 Bloomberg article:

"Funds overseeing money for California teachers and public workers, Dutch government retirees and South Korean private- sector employees reduced their target weightings for equities this year, data compiled by Bloomberg show. The rest of the 10 largest kept them the same. U.K. pensions have cut stock allocations to the lowest since 1974, according to Citigroup Inc. Managers handling Oxford and Cambridge University professors assets have been selling shares as the MSCI World Index posted a five-month, 51 percent rally."

Here are several more recent quotes from a June 11, 2010 article in Investments & Pension Asia

"Research for the survey was conducted in May 2010. Questions were sent to a wide cross-section of pension funds, almost half (46%) of which are corporate followed by public pension funds (30%) and endowments (8%). They have a total of $110bn under management. The pension funds have, on average, a 44% target allocation to equity, 37% to bonds, 16% to alternatives and 3% to cash.

Given the difficult environment in the lower-quality sovereign bond segment, investors six-month tactical views reflect a more moderate appetite for bonds (though it is far from negative). Indeed, most of the respondents do not anticipate any change in their bond target asset allocation in the next six-months while 13% anticipate an increase and 11% a decrease"

How are the Europeans looking at this issue? Here is a quote from a Finfacts Ireland April 2010 article:

"Mercer, the international pensions consultants, said on Thursday that the move away from shares is particularly evident in the more mature defined benefit markets such as the UK where the allocation has fallen from 54% in 2009 to 50% in 2010. In Ireland it has reduced from 60% to 59% and in the Netherlands from 28% to 23%. This trend is likely to continue, with 29% of UK schemes and 35% of European schemes (ex-UK) planning further reductions in domestic equity. A further 20% of UK schemes and 33% of European schemes (ex-UK) are planning a reduction in non-domestic equity.

Bonds continue to form the largest part of most European pension funds investment portfolios, and this looks set to continue. For example, following the significant rally in equity markets, a net 27% of European (ex UK) schemes plan to increase their exposure to government bonds."

So it would seem that institutional investors have no learned the lesson from their experiences in 1974. They are once again not taking a long term viewpoint and are extrapolating recent trends into the future. They ran out of stocks when they should have been buying them in the downdraft of 2008/2009 and are now increasing bond allocations when they should be increasing their large exposure to high quality equities. After all would you prefer owning a 10 year US Treasury Note yielding 2.69% (as of 08/17/1010) or high quality equities which in some cases can be purchased with yields exceeding 10 year bonds? For example JNJ just sold $550 million of 2.95% 10 year notes, has a P/E of just over 12 and sports a dividend yield of 3.7%. The choice, for me, would be easy.

The Park-Ohio Holdings Corp. gets the award this year for the shortest annual letter:

"ParkOhio was well positioned during 2009 to take advantage of growth opportunities that are currently developing in our core business. Hard decisions were made last year to ensure 2010 and subsequent years will be rewarding to our shareholders."

Contrast that letter with any annual letter written by the CEO of Techne at the link below: http://www.techne-corp.com/financial.asp

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